Looking hard at the big picture going into 2010
As 2010 opens, we would like to review the market’s condition and provide an outlook for investors. This has been a difficult year for the economy. Top economic concerns like the housing market and consumer spending continue to weigh heavily on financial markets. While near-term uncertainty in the economy has been difficult for investors, a bigger picture of financial market history could provide a helpful framework for considering the future as the new decade begins.
While the big picture of market history can be a helpful tool in shaping an investment outlook, current economic issues will dominate the near-term. In particular, the housing market is still having a difficult time staging a meaningful turnaround. Past-due mortgages are at high levels and could delay an eventual recovery. There are, however, some incremental signs of improvement as unsold home inventory has started to work its way down and home price indices have notched some recent gains. And over time, demographic forces should push demand for housing high enough to potentially offset the supply of foreclosed properties.
While waiting for the housing market to work through its issues, consumers are acting with extreme caution in the face of high unemployment. As widely reported, consumer spending is akin to the American economy itself, representing more than 70 percent of national earnings or GDP. But that statistic tends to oversimplify the situation because consumer spending consists mostly of nondiscretionary categories like food, housing and health care. Only 25 percent of consumer spending is purely discretionary, and while this portion of the economy is certainly at risk, the fact that holiday sales are up this year from last year is encouraging.
There is also growing concern about higher interest rates in the near future. Because U.S. deficits will continue to be funded with massive new debt — with Congress raising the federal debt ceiling as this article goes to print — U.S. Treasury bond buyers may eventually demand higher interest rates.
But higher rates may attract more investors, keeping an upper limit to a possible rise in interest rate levels.
In the midst of these significant and unresolved economic challenges, the stock market has baffled many with a massive rally. As we approached the end of the year, the S&P 500 index had gained nearly 28 percent and was up an amazing 67 percent from the dark days of March. That kind of rally in such a short time is extremely unusual, and many investors are skeptical about whether it can be sustained.
But there is a difference between stock prices, which have received little in the way of direct government support and have suffered terrifying losses, and the housing market, which is being propped up by ultra-low mortgage rates, tax credits, mortgage forbearance rules, etc.
Without the same kind of dramatic steps taken to arrest the housing market’s fall, stock prices were allowed to bottom as the entire financial system showed signs of unraveling. Indeed, some early comments from the Obama Administration seemed to even suggest an indifference toward the pain felt by investors. But in reaching epic lows — a peak-to-trough fall of 57 percent for the S&P — markets offered investors opportunities to purchase assets at historic low valuation levels. While the economic risks continue to be outsized, the case for investing again is building.
Against the backdrop of a struggling economy, and a stock market that has probably bounced in proportion to the amount of panic losses, where do we go from here? In the short-term, the market signals are mixed. But in the long-term, we point to something more concrete. It has been referred to as the most reliable behavior of financial markets: mean reversion. Markets tend to plod out a random day-to-day path that eventually resembles a long-term pattern of returns, with phases of erratic behavior that sooner or later average out to conform to what was previously the norm of positive stock market returns. This tendency of markets to revert to the average, or mean, can provide the framework for future expectations.
Unfortunately, equity returns over the last 10 years have been approximately zero, and some have referred to this period as a “lost decade.” Yet the history of financial markets makes a strong case that positive returns will eventually come back as the law of mean reversion gradually asserts itself in the day-to-day action of the equity market. More specifically, consider that since 1871 there have been 13 10-year rolling periods where equity returns have been negative. In each subsequent decade, the annual returns were always positive, with gains averaging more than 10 percent.
In view of the market’s unbroken record of reverting back to gains after 10-year periods of losses, at a minimum we need to be careful to balance strong bearish sentiment after already suffering a decade of negative stock market returns. We are not ignoring the problems in the economy. Rather, we are saying that investors, if anything, are even more concerned about the risk they are taking, leading them to demand greater return potential or threaten to boycott the market as many did in 2009 by avoiding committing new money to equity funds. A long period of poor market performance coupled with high levels of investor anxiety sets the stage for better future returns. As Richard Bernstein reminded his readers earlier this year, “bull markets are made from risk aversion and undervalued assets. … Return on capital is typically highest where capital is scarce.”
Scott W. Wagasky is principal, director of business development, with AMBS Investment Counsel LLC of Grand Rapids.